Institutions

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A country’s institutional environment has long been considered a determining factor of competitiveness, and will remain largely unchanged in the updated GCI. In the context of the current GCI, institutions are defined by two characteristics that reflect core features put forward by economic literature.4 First, institutions set formal, legally binding constraints—such as rules, laws, and constitutions—along with their associated enforcement mechanisms.5 Second, institutions include informal constraints such as norms of behavior, conventions, and self-imposed codes of conduct such as business ethics, and can be thought to include norms of corporate governance as well. By shaping the ways in which individuals organize themselves and their economic transactions, institutions form the backbone of societies.6 The differences among institutions explain many of the underlying reasons for the differences in technology and in physical and human capital between countries, which in turn explain a large part of cross-country differences in income.7

Ample empirical evidence has shown the importance of institutions for productivity,8 suggesting that their fundamental role consists in setting the right incentives and lowering uncertainty so that citizens can be confident in engaging in economic activities.9 Economic agents will invest only if they believe that they will reap expected benefits and returns on their work or investment without needing to spend excessive amounts of time and money protecting their property and monitoring the fulfillment of others’ contractual obligations.10 This depends, informally, on adequate levels of trust in society;11 it also depends, formally, on the existence of institutions capable of ensuring a basic level of security and enforcing property rights. This in turn relies on the institutions’ political set-up and power structure, characterized by (1) the incidence of transparency, (2) efficiency of the public sector, and (3) the existence of checks and balances.

Economic literature has documented the importance of enforceable property rights for the economy12—that is, the right of control over an asset and the returns it may generate provides incentives to invest (in physical or human capital or technology), create, innovate, trade, and maintain. If physical or financial property cannot be acquired and sold with confidence that the authorities will endorse the transaction over the long run, economic growth will be undermined. An absence of property rights also drives people out of formal markets into the informal sector. De Soto suggests that no nation can have a strong market economy without adequate participation in a framework that enforces legal ownership of property and records economic activity, because they are the prerequisites to obtaining credit, selling properties, and seeking legal remedies to conflicts in court.13 Ensuring the protection of property rights is therefore a key role of the state.

Another fundamental role of the state is guaranteeing the security of its citizens, which is a minimal requirement for incentivizing economic activity. Violence, racketeering, organized crime, and terrorism all constitute substantial disincentives to private investment and economic transactions. Empirical research provides evidence that homicides, robbery, extortion, and kidnapping can crowd out investment;14 and organized crime can generate misallocation of capital and labor and act as a barrier to enter a market.15

Although the two roles of the state provide a raison d’être for formal constraints, their implementation depends on the quality of institutions. Research shows that three characteristics of institutions determine their quality. The first is an absence of corruption and undue influence. Broadly understood as the misuse of public power for private gain, corruption interferes with the allocation of resources to their most efficient uses and undermines growth in five main ways: (1) it diminishes incentives to invest, because economic agents view corruption as a species of tax; (2) it leads to a misallocation of human capital, because talent is incentivized to engage in rent-seeking activities rather than productive work;16 (3) it results in loss of tax revenue; (4) it pushes inappropriate public spending, because government officials are tempted to allocate expenditures less on the basis of promoting public welfare than on the opportunity they provide for extorting bribes;17 and (5) it lowers the quality of infrastructure and public services through the misallocation of public procurement contracts.18

The second determinant of institutional quality is efficiency in the public sector, which has two aspects: efficient administrative services and a stable policy environment. Administrative efficiency implies a lack of unnecessary red tape in business processes such as the collection of taxes, compliance with regulations, obtaining permits, and the judicial system; there is empirical evidence that burdensome bureaucracy decreases investments and firms’ efficiency.19 Policy stability may affect productivity by reducing uncertainty about the future and consequently expanding the time horizon of society’s preferences; this may lead to better resource allocation, including more R&D investments and hence faster technological progress.20

Finally, quality institutions are endogenous—that is, the rules governing human interactions are the result of choices made by those in power, selected on the basis of the rules they set. Separation of powers, and especially the independence of the judiciary,21 has long been recognized as pivotal to preventing those in power from arrogating absolute power or shaping economic institutions to benefit themselves at the expense of the rest of the society.22 Branches of governance represented by the separate powers should be able to hold each other reciprocally accountable for the discharge of the powers apportioned to them by law.23 It is the extent to which this actually happens in practice—not merely that it is provided for in principle in a country’s constitution—that matters.24

In addition to the quality of public institutions, corporate ethics and governance standards determine incentives for companies, investors, and society to engage in economic activities. Strong corporate governance standards contribute to productivity in two ways. First, they enable shareholders to exert control over firms, and shareholder value in turn is maximized by raising the firm’s productivity. Second, by aligning incentives of firms’ managers and owners, they limit risks to investors, incentivizing higher levels of investment and reducing costs of capital for the firm. Key to corporate governance is the transparent access of shareholders to timely and accurate information, accountability of management to strong and independent corporate boards, and auditor independence.25 In addition to formal standards, informal behavioral norms also play a crucial role in the way businesses are run. High ethical standards among business leaders can contribute to building trust, thereby reducing the cost of capital and compliance.

4
Our definition is loosely based on the work of North 1994. Hall and Jones 1998, for instance, follow a narrower definition and refer to institutions as social infrastructure that avoids diversion, which can be undertaken either by private agents (thievery, squatting, and mafia protection) or by public agents—that is, the government itself (e.g., expropriation, confiscatory taxes, and corruption).

5
The idea of an individual submitting either explicitly or implicitly to the authority of a ruler in exchange for protection of their remaining rights has been discussed in the concept of social contract, most prominently put forward by Thomas Hobbes (Leviathan, 1651), John Locke (Second Treatise of Government, 1689), and Jean-Jacques Rousseau (Du contrat social, 1762).

6
Adam Smith, in his Wealth of Nations (1776), was among the first to put forward the importance of institutions: “Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to be regularly employed in enforcing the payment of debts from all those who are able to pay. Commerce and manufactures, in short, can seldom flourish in any state in which there is not a certain degree of confidence in the justice of government” (Book V, Chapter 3 “Of Public Debts,” paragraph 7).

7
See Acemoglu 2009 for an exhaustive discussion on institutions and the fundamental causes of economic growth. According to Acemoglu, potential fundamental causes of economic growth may be (1) luck, leading to divergent paths among societies with identical opportunities, preferences, and market structures; (2) geographic differences that affect the environment in which individuals live and that influence the productivity of agriculture, the availability of natural resources, certain constraints on individual behavior, and even individual attitudes; (3) institutional differences that affect the laws and regulations under which individuals and firms function and thus shape the incentives they have for accumulation, investment, and trade; and (4) cultural differences that determine individuals’ values, preferences, and beliefs.

8
For example, North and Thomas 1973 discuss a system of property rights as the key to growth. Hall and Jones 1998 find that differences in capital accumulation and productivity, and therefore output per worker, are driven by differences in institutions and government policies. Acemoglu et al. 2001 show that institutions are robustly related to present-day differences in per-capita incomes. Rodrik et al. 2002 find that property rights are more important than either geography or trade in determining income levels around the world.

9
North explains, “[t]he major role of institutions in a society is to reduce uncertainty by establishing a stable (but not necessarily efficient) structure to human interaction. The overall stability of an institutional framework makes complex exchange possible across both time and space” (North 1990, p. 6).

11
Trust within society reduces transaction costs of economic activities. Franke and Nadler 2008 define a nation’s ethical attitude as people’s “cognitive, affective, and behavioural predispositions to react to issues and activities involving social standards for what is morally proper and virtuous” and show that it significantly predicts economic performance.

12
For example, Acemoglu et al. 2001 focus on the expropriation risk that current and potential investors face. Examples from literature in support of these ideas include Banerjee and Iyer 2005, who analyze the colonial land revenue institutions set up by the British in India and show that differences in historical property rights institutions lead to sustained differences in economic outcomes; De Soto 2000, who shows that owners of land, corporate shares, and even intellectual property are unwilling to invest in the improvement and upkeep of their property if their rights as owners are insecure; Acemoglu et al. 2005, who discuss the detrimental effects on growth in the Middle Ages and early Modern Period from of the lack of property rights for landowners, merchants, and proto-industrialists on growth in the Middle Ages and early Modern Period; and Knack and Keefer 1995, who show that security of property rights affects the efficiency with which inputs are allocated by inhibiting activities (rent-seeking, theft, arbitrary confiscation, and/or excessive taxation) that reduce individual incentives.

13
De Soto’s influential book The Other Path: The Invisible Revolution in the Third World (1990) has significantly impacted economic development policies and led to the creation of the World Bank Doing Business framework.

15
For example, Pinotti 2014 explores the various channels through which organized crime stifles growth. Mafia rackets lead to misallocation of capital and labor by forcing firms to purchase overpriced inputs or hire individuals based on their connections to the organization; they may prevent new entrepreneurs from entering the market; and their influence on politicians and public officials can divert public investments and interfere with the selection of public officials.

17
Shleifer and Vishny 1993 show that the structure of government institutions and of the political process are important determinants of the level of corruption and that the illegality of corruption makes it much more distortionary and costly than taxation. Mauro 1997 presents evidence that corruption distorts public expenditures away from growth-promoting areas such as education and health toward other types of projects.

18
Tanzi and Davoodi 1997 find that corruption diverts public funds to areas where bribes are easiest to collect and toward low-productivity projects—for example, new construction rather than maintenance of existing infrastructure—resulting in rising public investment but lower social welfare and reduced impact on productivity.

19
Ayal and Karras 1996 construct a measure of bureaucracy for OECD countries and show that higher levels of bureaucracy are negatively related to economic growth. Loayza et al. 2005 conclude that a heavier regulatory burden—particularly in product and labor markets—reduces growth and induces informality.

20
Aisen and Veiga 2013. Also, Alesina et al. 1996 show that growth is significantly lower in countries where the propensity of a government to collapse is high. Jong-A-Pin 2009 uses a measure of multidimensional instability of the political regime to show that it has a robust and significant negative effect on economic growth.

24
Feld and Voigt 2003 show that, for a sample of 66 countries between 1980 and 1998, the factually ascertainable degree of judicial independence positively influenced GDP growth, but no such impact was found when looking only at the legal foundations of judicial independence. Their findings show the importance of de facto versus de jure on economic growth (only first one is significant).